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Our VIX model’s fair value has recently spiked to above 26, more than 10 points above spot, and 7 points above forwards. This is meaningful. As we will explain below, we strongly believe that equity volatility, which we view as an asset class, is a now a buy.

Corporate balance sheet leverage

When corporate balance sheet leverage rises, default probability increases down the line. We use two sets of indicators to track it.

The first one is our own definition of the financing gap. The FED only looks at the difference between internal funds and capital spending. We prefer adding to that equation the net amount of equity issuance (positive when issuance > shares buyback and negative when it is the opposite). The logic is straightforward. Shares buybacks drain liquidity away from balance sheets while share issuance replenishes coffers. When, like in 2007 or today, debt issuance is used to buy back shares, the impact on leverage is very substantial. In our model, it is captured by our second input tracking balance sheet strain: private sector credit growth. In the financial account of the United States, we look at non‐financial corporate business total credit instrument liability year on year growth rate.

The two mentioned indicators give us information on the financing needs of the private sector (rising leverage = rising financing needs) and debt accumulation.

Today, shares buybacks equal 25% of cash flows.

The financing gap as we measure it has risen back to around 4% of GDP.

Private sector credit growth is rising fast, bank loan growth is running at almost 15% yoy, while total credit market instrument is rising at close to 10% above the last 3 years’ trend. In 2000 and 2007, it had reached 14% and 13% respectively. Since it works with a lag, the rapid debt accumulation over the last 6 years should only now start to impact balance sheet health.

Credit availability

Credit availability is another important input since, as long as credit is cheap and available, companies can roll over debt, minimizing default risk in the short term.

Bank lending behavior used to be the main indicator that we used, simply because banks were until recently the main suppliers of liquidity to the private sector through loans (this is still the case in Europe but not anywhere else). To track this supply side of the credit channel, we use the senior loan officer survey.

Bank lending behavior remains ample. The % of banks tightening lending standards is negative (banks on average are still easing terms). Nevertheless, there is no better indicator than the financing gap to anticipate bank lending attitude. The recent sharp releveraging implies that loan officers will soon react to this balance sheet health deterioration.

As they should, since rising financing needs cripple corporate profits down the line….

Our bank lending behavior model sees lending standards in the US being tightened this year:

However, as the BIS recently highlighted, the ratio of loans to corporate bonds has collapsed over the last 20 years in the US. This is why, now that investors have become the main providers of capital to the private sector, it is essential to look at risk appetite/sentiment set of indicators to evaluate that part of the supply dynamic.

On the investors’ sentiment front, the picture is we think quite worrying. The best measure of investors’ risk appetite is high yield corporate credit spreads. They have been widening since last summer in part due to the oil crash, but not only.

If we look at FX volatility, which is another good proxy for risk appetite, it is the same story. FX volatility is, in our opinion, a major input. When it rises, hedging overseas profits becomes more expensive, and overall visibility for global CEOs gets much more blurred.We have used EURCHF as a risk appetite proxy for a very long time. Back in Q3 2010, we warned that Europe was in a meltdown as evidenced by the massive capital inflows into Switzerland. The EURCHF was crashing and its implied volatility soaring. Six months later, equities were plummeting and risk appetite completely gone.

This is exactly what is happening today. Just like back then, most investors we speak to tell us that European QE, which is responsible for the EURCHF turmoil, is a good thing for risk appetite. We agree, but we would add that the CHF strength, just like a host of historical indicators of risk aversion, tell us that at the global level, there has been no appetite for risk since last summer.The MSCI World is flat since July, corporate credit spreads are widening everywhere, commodities and FX volatility have soared since then, and financial conditions have tightened globally as a result.

Retail investors’ sentiment is also important since they hold a lot of corporate debt through mutual funds or ETFs. Their sentiment remains bullish but it is probably the most volatile of all, and one that should be looked at more from a contrarian point of view, especially at extremes like is the case today.

Earnings revisionsCash flows are the last variable bloc of our model. To repay debt, a company needs stable to rising cash flows. Earnings thus need to be watched closely. We look at earnings revisions (the one month change on 12mth forecasts) as the best leading indicator for expected cash flow momentum. Negative earnings revisions imply weakening cash flows and inversely.

It is astonishing to realize that today, earnings revisions are the most negative since 2008, and almost equal to the peak level of the 2002 bear market, while US equities have just printed a new historical high. Earnings forecasts are being revised lower at an alarming pace, mostly because of the dollar’s strength but also because capital goods spending are being cut aggressively. In the meantime US equities are being lifted on the back of European and Japanese QE. This tells us that we could be in the very final stages of the equity bull market that started 6 years ago. Complete disconnect between fundamentals (earnings) and prices are a classic signs of a top formation.

The current environment reminds us of 2011 but totally reversed. Back then, US earnings revision were strong, balance sheet were still healthy, and credit availability was large. As a consequence, the VIX fair value was substantially lower than spot level. Fears about the Eurozone sovereign crisis pushed US equity volatility to levels completely unjustified by US fundamentals. In time, the VIX converged towards its fair value. Today, US fundamentals have deteriorated but equities are at historical highs and volatility in the mid 10s. We think that unless earnings estimates are not revised upwards very quickly, a burst of downside volatility will materialize. Between 2009 and 2012, selling equity implied volatility was part of our investment strategy. For the first time in more than 6 years we are now looking to buy it.While timing a market top can be costly and energy consuming, we are convinced that equity volatility will soon rise very sharply. Equity prices could rotate in a range for a while longer before moving down, but volatility will rise in the process.Furthermore, the US dollar strength is tightening financial conditions globally. Because cheap dollar funding has infiltrated the corporate world from Moscow to Beijing and Sao Paolo, defaults will inevitably rise together with equity volatility. Implied volatility bottomed exactly when the US dollar started rallying in July 2014. This is because in a world where the stock of dollar credit to non‐banks outside the United States has reached $9.2Trn, to which we should also add sovereign debt in USD, a sharp appreciation of the US currency equals a sharp tightening of financial conditions for non US borrowers. And we know that tighter financial conditions imply increased risks of defaults and hence higher volatility.

All the factors mentioned above (balance sheet leverage, private sector credit growth, credit availability) are even more stretched for Emerging Market equities.The EM Earnings Revision Ratio is weak.Private sector credit growth has been buoyant since 2009, dollar denominated debt has spiked, rising at close to 15% every year since 2009. EM corporates balance sheet leverage has significantly risen as a consequence.The credit channel, as evidenced by the IIF EM lending survey, is tightening domestically. The EM currencies crash vs. the dollar are tightening financial conditions even more. NPLs are on the rise. Rating downgrades are accelerating sharply. In Q4 2014 there were 111 more downgrades than upgrades, up from 26 in Q3. In 2015, there has already been 56 net downgrades.As downgrades outnumber upgrades, the weakest borrowers are shut from capital access, which exacerbates further the default cycle, which leads to more net downgrades and so on: a classic negative feedback loop.The situation in China is probably worse than anywhere else. If we had proper data on corporate financing needs, balance sheet leverage and credit availability, the fair value on HSCEI implied vol would be we believe quite elevated. It is also interesting to highlight that all previous housing downturns triggered a spike on volatility. Housing prices are now down 5.5% yoy, and with 69 out of 70 cities registering negative yoy prices, the momentum on the downside is alive.

Emerging market implied volatilities are interestingly cheap today.If we look at EEM, the 12mth implied volatility it is at the 8 percentile so is the 12mth implied ratio with SPX (7 percentile)EEM, KOSPI and HSCEI implied volatilities are cheap on both an absolute and relative basis.

"Logic is the technique by which we add conviction to truth.' - Jean de la Bruyere

Tuesday, 24 February 2015

"Nothing is perfect. Life is messy. Relationships are complex. Outcomes are uncertain. People are irrational." - Hugh Mackay, Australian scientist

While continuously following the evolution of the Euro convolution, with the temporary relief of the outcome for a Greece and the high probability of a Grexit in the end, as well as looking at the continuous fall in one of our favorite global demand indicator namely the Baltic Dry Index falling below its 1986 level towards 513 on the 22nd of February, we reminded ourselves for our title analogy of the Pigou effect, which is the stimulation of output and employment caused by increasing consumption due to a rise in real balances of wealth, particularly during deflation. For Arthur Cecil Pigou, real wealth was simply defined as the sum of the money supply and government bonds divided by the price levels. He argued that when an economy was in a liquidity trap, monetary stimulus to increase output could not be used given there is little connection between personal income and money demand. Of course what we find of interest is that if the Pigou effect had been effective, then Japan should have exited deflation much sooner. Pigou, (just like our central bankers of the world today) hypothesized that falling prices would make consumers feel richer (and increase spending, that famous "wealth" effect) but Japanese consumers tended to report that they preferred to delay purchases, expecting that prices would fall further, which of course is exactly what has been happening.
It appears that "The Pigou effect" has been highly criticized as well by Michał Kalecki because: "The adjustment required would increase catastrophically the real value of debts, and would consequently lead to wholesale bankruptcy and a confidence crisis."

But, when it comes to our title analogy and the "Pigou effect", we find it quite amusing that Pigou had been John Maynard Keynes' professor. Pigou's theory is completely flawed as it is based on the hypothesis that there cannot be a prolonged period of overproduction (China) and the artificial life support of "zombie" companies (European banks, Chinese shipping companies, etc). Arguably, the trajectory of the Baltic Dry Index is indeed putting to the test that very assumption from the University of Cambridge professor. It is interesting to note that his student, John Maynard Keynes argued that a drop in aggregate demand could lower both employment and the price level in unison, an occurrence observed in the deflationary depression, which is what we are currently seeing in Europe and what is also coined by some economists the "Keynes effect":

"The effect that changes in the price level have upon goods market spending via changes in interest rates. As prices fall, a given nominal money supply will be associated with a larger real money supply, causing interest rates to fall and in turn causing investment spending on physical capital to increase." - source Wikipedia

Of course both the teacher and the student were wrong, as the former ignored the probability of extended oversupply and the latter implied that insufficient demand in the product market cannot exist forever. The Keynes effect does not occur in a "liquidity trap" according to "Keynesians", which is the result we are seeing in Europe with lack of aggregate demand due to lack of private credit as most European banks as they are constrained by their inherent "lack of capital". It is also particularly due to ZIRP and the Zero Lower Bound Problem. The result of this "liquidity trap" is, for us, self-inflicted. We discussed the issue of "crowding out" of the private sector in our conversation "Fears for Tears":

One of main reason of the relative calm in the European government bond market has been the "crowding out" of the private sector."Although, the intention of European politicians has been to severe the link between banks and sovereigns, in fact what they have effectively done in relation to bank lending in Europe is "crowding out" the private sector. Peripheral banks have in effect become the "preferred lender" of peripheral governments. It is fairly simple, in effect while the deleveraging runs unabated for European banks, most European banks have been playing the carry trade and in effect boosting their sovereign holdings by 30% since 2011 to record"

In this week's conversation we will take another look at the long term prospect for the European banking sector, as we strongly sit in the deflationary camp. We believe that rates will stay low for longer, particularly in Europe, which is caught in a vicious "japanification" process. We will also reassess some of our earlier views (long US treasuries, long Gold, short JPY), particularly in the light of the increased volatility and the impressive rise in US yields during the month of February which we highlighted in our most conversation.

Synopsis:

The "crowding out" effect

Banks stocks or credit?

Banking crisis? Sweden lead the way

Why Pigou failed in Japan and why QE is like aspirin? It's the demography stupid!

Reassessing some of our earlier views

The battle against the deflationary bust looming will not be won by ZIRP and QEs

Real wage growth is the Fed's greatest headache

Volatility is a buy and will greatly impact negative convexity assets

On the fallacy of "Balance accounting" as per Sir James Goldsmith

The "crowding out" effect:

The "crowding out" effect we mentioned on numerous conversations pushes yields down further meaning bonds investors are having a field day. Weak demand and ZIRP entices speculations and buy-backs rather than investments and employment. Banks play heavily the carry trade and therefore increase their link to their respective sovereigns while the private sector (SMEs) hasn't been able to easily access credit, leading to a credit crunch in Europe in the last couple of years triggering weaker aggregate demand, surging unemployment, etc.

In similar fashion to Japan, government bonds have replaced private sector lending on European banks' balance sheet. The comparison between Japan and Europe in terms of "evergreening" bad loans (extend and pretend that is, such as "shipping loans" for instance) and impaired financial sector can be ascertained from German bank Berenberg's note entitled "Turning Japanese...we really think so" published on the 10th of February.

"Policy responses – lessons not learned: In terms of fixing the banking system (the need to recapitalise banks rapidly and early on) and monetary policy (the need for shock and awe), European policy makers appear to be aware of, but have not taken on board, the lessons from Japan or the US in the 1930s. Perhaps, like their Japanese peers before them, they believe the economy is facing cyclical not structural challenges, or maybe they are concerned about their reputations or wish to prevent panic. But to be clear: fixing the European banking system remains unresolved and will remain so until hidden loan losses are dealt with.
● Interest rates will be lower for longer than anyone is prepared for: Deflationary forces arising from the balance sheet recession will see loose monetary policy
persist for another 10-15 years. For European banks, the implications are clear.

o Balance sheet structures to transform: Private sector deleveraging, continuing fiscal deficits and tightening regulation will make balance sheets smaller, drive the loan-deposit ratio below 100%, see (sovereign) fixed income assets double their share of bank assets, and lead to ever increasing equity-to-assets ratios.
Non-performing loan (NPL) ratios may yet double as they did in Japan following the onset of deflation.
o Balance sheet profitability to decline: Flat yield curves close to the zero bound and a substitution of private sector loans with sovereign bonds will push the net interest margin lower for many years to come. Combined with elevated loan losses, returns on assets (RoAs) will remain at half the levels of the precrisis, golden age.

● Share price and valuation parallels offer no support: The parallels with Japan have also held at a share price and valuation level, and suggest that there remains considerable relative downside to come (30-40%?) for European banks." - source Berenberg

Japan and the "crowding out" effect as illustrated by Berenberg in their lengthy note:

- source Berenberg

Banks stocks or credit?

As we have stated on numerous occasions, when it comes to European banks, you are better off sticking to credit (for now) than with equities given the amount of "deleveraging" that still needs to happen in Europe. This can also be ascertained by the comparison in terms of returns for banks between Japan and Europe as highlighted by Berenberg in their great note:

"Given the continuing poor disclosure of loan quality by the European banks, we cannot say for certain what the capital deficit really is. However, history consistently shows that at the end of a 60-70 year debt cycle when an extended balance sheet recession takes hold, there are substantial hidden loan losses. But at some point, in the face of continuing weak nominal economic growth, banks must move from forbearance to foreclosure within their loan books and thus crystallise the loan losses." - source Berenberg

"First bond tenders, then we will probably see debt to equity swaps for weaker peripheral banks with no access to term funding, leading to significant losses for subordinate bondholders as well as dilution for shareholders in the process." - Macronomics - 20th of November 2011.

The extend and pretend game of hidden losses has been of course been supported by both LTROs and by now the much anticipated ECB QE. So, forget about "dead cat bounces" in European banks share prices, as Japanese history has shown, pain is here to stay for shareholders as illustrated as well clearly by Berenberg:

"In Figure 29 we compare the relative performance of banks against the market in Europe and the US with that of Japan (with the Europe/US data rebased by 11 years to map the timescale of Japan). The good news is that the material relative underperformance of Eurozone, UK and US banks matches that of Japan both in terms of scale and duration. The bad news, however, is that the worst is not over. Japanese banks staged a three-year rally on the back of the restructuring of the banking system driven by the 2002 Takenaka plan (which forced the recognition of NPLs and the recapitalisation of banks). However, the underperformance resumed over the last eight years and Japanese banks are now at close to their 40-year+ relative lows. With Europe yet to achieve closure on balance sheet uncertainty (ie achieve a successful restructuring of the banking system) and with flat yield curves at the zero bound squeezing net interest margins, European banks are likely to continue to grind lower relative to the market. Further, as we show in Figure 30, banks do not like QE. In Japan and the US, banks underperformed during episodes of QE (QE flattens yield curves thus squeezing net interest margins and also signals an environment of low nominal growth which is negative for asset quality)."

- source Berenberg

Banking crisis? Sweden lead the way

When it comes to the outperformance of "Nordics" share prices versus Japanese banks as displayed above it can be very simply explained. Sweden decided to tackle head on the issues of its ailing banking sector on numerous occasions. Sweden has a good firsthand experience of financial crisis unlike Europeans.

Sweden suffered through a banking crisis in the early 1990s and then again in 2008 and 2009. It chose to inject capital into struggling banks only in return for equity to avoid raising deficits and burdening taxpayers. The government in 2008 set up a financial stability fund by charging banks an annual fee and enacted various crisis-management measures including a bank guarantee program to help support lending.

The fund will grow to 2.5 percent of gross domestic product by 2023 and stood at 35 billion kronor ($5.2 billion) at the end of 2010, including shares in Nordea Bank AB, according to the Swedish National Debt Office.

As far as European banks are concerned, regardless of the European Banking Union, AQR and other shenanigans, we agree with Berenberg's take on the triviality of the AQR adjustments:

"The triviality of the AQR adjustments was the most damning in our view. It is simply not credible that at the end of a 60-70 year debt cycle and after seven years of near nonexistent economic growth that the adjustment to Non-Performing Exposures equalled just 62bp of total assets. Charitably, this could be blamed on IFRS and its requirement to only identify losses on an “incurred” basis rather than expected one (indeed, rephrasing the critique given IFRS only allows provisioning on an incurred basis and given the adjustments were so trivial, it must imply that the ECB acquiesced in covering up the scale of hidden losses in banks’ balance sheets). Indeed, as Hoshi and Kashyap wrote presciently in October 2013, the European authorities “appear to be hesitant to admit to the size of the problems facing the banks” perhaps out of fear of triggering a panic.

In short, until there is true clarity in the value of European banks’ assets, then the value of the equity is highly uncertain, making European banks uninvestable. In our view, what Europe needs to do, and what happened in Japan, is to force banks to dispose of a material proportion of their non-performing loans. As shown in Figure 36, NPLs were over-valued for in excess of a decade.

Such forced disposals should help achieve price discovery around the true value of bank assets. And in turn, this should pave the way to achieving confidence around the capital bases of the European banks." - source Berenberg

Why Pigou failed in Japan and why QE is like aspirin? It's the demography stupid!

In relation to our title the "Pigou effect" and central banks' intervention leading to a "liquidity trap therefore neutralizing the "Keynes effect" , Japan is clear illustration of the failure of the "wealth effect" of Pigou's proposal as pointed out by Berenberg:

"In Japan, where the burden was shifted early on from monetary to fiscal policy, a Catch-22 is emerging. The Japanese government cannot afford to allow rates to rise, yet keeping rates low risks increasing distortions in the economy through the mispricing of risk. It has been estimated that a 2ppt increase in average bond yields would require almost all tax revenues to be used to service the government’s debt. Thus QE and the monetisation of the national debt must continue in size (apparently the Bank of Japan purchases the majority of all new debt traded) until the Bank of Japan owns most of the government’s debt. But if the quantity of something is increased and demand is constant then the price must fall, ie the yen must weaken further (and Japan exports deflation).

As noted in the previous section, abundant liquidity and low interest rates squeezed net interest income for Japanese banks (two-thirds of the revenues for a typical bank). This arose through two effects. Ample liquidity and a lack of private sector demand for credit meant that the Japanese banks materially increased their holdings of government bonds (with typically lower yields than private sector loans). Secondly, low interest rates and QE flattened the yield curve, reducing the benefit of the maturity transformation.

Markets are rejoicing that the ECB is finally following the Bank of Japan and other central banks in embracing QE. But what if, as Kiyohiko Nishimura observed (the former deputy governor of the Bank of Japan), the problems facing Europe and Japan are driven by a demographic not financial cycle. He has noted that in Europe and Japan, as well as the UK and US, crises have almost always coincided with a decrease in the ratio of the working-age population to the non-working age population":

- source Berenberg

You probably better understand now much better our long standing deflationary stance and lack of "appetite" for European banks stocks (we are more credit guys anyway...). It's the demography stupid! Beside's that we have pointed out in our conversation "Stimulant psychosis:

"Rentiers seek and prefer deflation - European QE to benefit US Investment Grade credit investors. Rentiers seek and prefer deflation. They prefer conservative government policies of balanced budgets and deflationary conditions, even at the expense of economic growth, capital accumulation and high levels of employment."

Both the master Pigou and the student Keynes have inadvertently grant unprecedented capital gains to rentiers in the form of exorbitant bond price! Exorbitant bond prices? How about Portuguese 10 year bonds at 2.13% trading briefly below US 10 year bonds?

Reassessing some of our earlier views

Duration - party on Wayne! party on Garth!

While we endured the proverbial battering on our long duration exposure during February (offset somewhat by our short JPY stance), as discussed in our last conversation, the latest raft of weaker than expected US data such as US home resales falling to their lowest level in nine months last month at an annualized rate of 4.82-million units, as well as Industrial companies indicating they would only raise capacity by 1.8 percent in 2015, which is the smallest increase since 2011, after boosting it 3.1 percent in 2014 according to the Fed said in its Feb. 18 release on production, reinforce our view that we have probably seen the top of widening move in US yields for the time being. The current levels make it interesting to think about increasing slightly more our own long duration exposure.

Gold - everything that glitters...

In terms of flows, it seems precious metals saw their first outflows of $0.3bn in 5 weeks according to Bank of America Merrill Lynch "The Flow Show" from the 19th of February entitled "Out with the Safe, In with the Risk":

Our gold and duration calls from our conversation of the 6th of January entitled the "Fright of the Bumblebee" performed well in January and got punished in February:

"In terms of "allocation", we think we are looking more towards the upper left part of the Credit Channel Clock which means:
-a continuation of flattening yield curves,
-being long volatility as we enter a higher volatility regime
-a continued exposure to US long government bonds. Long dated US government bonds from a carry and roll-down perspective continue to be enticing at current levels compared to the "unattractiveness" of the mighty German 10 year bund indicating a clear "japanification" process in Europe.
-adding again some gold exposure in early 2015. We hinted a "put-call parity" strategy early 2014, eg long Gold/long US Treasuries as we argued in our conversation "The Departed", it is going to be working again nicely in the first part of 2015"

The latest US raft of economic data has given some support of the $1200 level. We still remain positive for gold prices, given the lack of clear resolution of the Greek situation in conjunction with geostrategic tensions flaring with interventions looming in the Middle-East and with Ukraine 's economy in complete meltdown.

The battle against the deflationary bust looming will not be won by ZIRP and QEs:

Looking at the global economy as a whole, we think the globalization of ZIRP is not reducing the deflationary forces at play but in fact reinforcing them, pushing us towards additional currency war which is reminiscent of the build up towards the crash of 1929 and the Great Depression that ensued. On that specific matter we share Dr Lacy Hunt's views and concerns. He is the Executive Vice President of Hoisington Investment Management and gave a month ago a long interview with Gordon T Long on the current economic situation. While gathering our thoughts since our previous conversation, we also took into interest in the wise but gloomy comments from Hedge Fund manager Crispin Odey given in an interview with Nils Pratley in the UK newspaper The Guardian on the 20th of February:

“1994 is when we were all slathering about the idea of a world economy, and what it is going to do as we open up,” says Odey.“And Goldsmith basically says: ‘Hey, be careful about this because it is fine to have trade between peoples who have the same lifestyles and cost structures and everything else. But, actually, if you encourage companies to relocate and put their factories in the cheapest place and sell to the most expensive, you in the end destroy the communities that you come from. And there will come a point where the productivity gains from the cheapest also decline, at which point you have a real problem on your hands’ – And we are kind of there.” - source The Guardian

In response to the critics, Sir Jimmy Goldsmith wrote a lengthy but great thoughtful reply called "The Response" (link provided):

"Hindley would prefer to reduce earnings substantially rather than 'block trade'. In other words, he would prefer to sacrifice the well-being of the nation rather than his free-trade ideology. He has forgotten that the purpose of the economy is to serve society, not the other way round. A successful economy increases wages, employment and social stability. Reducing wages is a sign of failure. There is no glory in competing in a worldwide race to lower the standard of living of one's own nation. " Sir Jimmy Goldsmith

"Despite that one bright moment in the late 1990s, U.S. real average hourly wages haven’t budged much for decades. The U.S. average hourly wage of $20.80 in January 2015 is about the same as that in January 1973, adjusted for inflation, according to the Bureau of Labor Statistics." - source Wharton University

This is exactly the issue for the US economy as we stated back in July 2014 in our conversation "Perpetual Motion":

"Unless there is an acceleration in real wage growth we cannot yet conclude that the US economy has indeed reached the escape velocity level given the economic "recovery" much vaunted has so far been much slower than expected. But if the economy accelerates and wages finally grow in real terms, the Fed would be forced to tighten more aggressively." - source Macronomics, 22nd of July 2014

Real wage growth, we think is the most important indicator to follow we think from a Fed tightening perspective.

We also indicated at the time:

"Unless there is some acceleration in real wage growth which would counter the debt dynamics and make the marginal-utility-of-debt go positive again (so that the private sector can produce more than its interest payments), we cannot yet conclude that the US economy has indeed reached the escape velocity level." - source Macronomics, 22nd of July 2014

Volatility is a buy and will greatly impact negative convexity assets

From a market perspective, we recommended in our first conversation of 2015 that investors needed being long volatility as we enter a higher volatility regime, this is confirmed by the rise in the CVIX index (CVIX index = DB currency implied volatility index: 3 month implied volatility of 9 major currency pairs) as displayed by Bank of America Merrill Lynch in their Liquid Insight note from the 23rd of February entitled "Letting the data speak again on G10 FX":

"This is just the beginningWe expect that the year so far is a preview of what will follow. Our year-ahead had argued FX volatility would increase as data dependence replaces forward guidance in monetary policy, ECB and BoJ QE would not be enough to replace Fed QE as boosters of global risk appetite, and oil prices would be lower and more volatile. In the global monetary union with the US we pointed out that loose Fed policy and forward guidance in G10 central banks had killed market volatility and FX correlations with data and fundamentals, and argued volatility and such correlations would come back as Fed QE ends, G10 monetary policies diverge and USD strengthens.We believe these forces remain valid. We recently argued FX volatility has become the prime driver of global volatility, as central banks react differently to the common oil price shock and some are behaving as if they are in a currency war. The latest FOMC minutes also suggest the Fed is unlikely to continue ignoring the drop in inflation expectations, suggesting the upward USD." - source Bank of America Merrill Lynch

As a reminder and going forward, the greater the volatility, the greater the disadvantage of owing negative convexity bonds like you find in the High Yield space. In the current low yield environment, both duration and convexity are higher, therefore the price movement lower can be larger!

On the fallacy of Balance accounting as per Sir James Goldsmith

"The idea that accounts must balance, and that inflows must ultimately match outflows, is an accountant's idea.But there is a fundamental misunderstanding here. If you make a loss, perhaps because you own a business that is trading unprofitably or because you have made a bad investment, you will not get rid of the loss by borrowing the amount needed to pay for it. You will have avoided or postponed a personal liquidity crisis, but you will still be poorer by the amount of the loss. You will also have to pay interest on the loan.Alternatively, you might sell your house and rent somewhere else to live. You will have used the proceeds of the sale to pay your debts, but you will remain poorer by the value of the house. And in future, you will have to pay rent.When the Asian countries, as mentioned by the European Commission, invest their 'excess cash' abroad, normally they do so by buying into businesses or by lending money. The latter normally takes the form either of buying government debt or of deposits, say in sterling or dollars, in the banking system. Now consider the position of the nations which, unlike the Asian countries, import more than they export and which, as a result, have a deficit as opposed to an excess of cash.To finance their deficit, businesses or other assets are sold and debt is issued. This puts them in exactly the same position as an individual who sells his house or borrows money to cover his debts. Such a haemorrhage can last only a limited time before ending in bankruptcy." - Sir Jimmy Goldsmith

Hence the need for central banks to issue more debt to sustain the global financial system...until it doesn't work but that's another story...

Thanks to Global ZIRP and our central bankers we are indeed living on the Planet of the Apes...oh well.

Wednesday, 11 February 2015

"It ain't what you don't know that gets you into trouble. It's what you know for sure that just ain't so." - Mark Twain

Looking with interest at the latest surge in the US 10 year yield to 1.94% in conjunction with the "improved" employment picture in the US as well as the fall to record low level of 1986 for the Baltic Dry index to 559, we remembered one of our favorite song from the Beatles "While My Guitar Gently Weeps" recorded in 1968 for our title analogy. "While My Guitar Gently Weeps" was ranked no. 136 on Rolling Stone '​s list of "The 500 Greatest Songs of All Time", no. 7 on their list of the 100 Greatest Guitar Songs of All Time, and no. 10 on their list of The Beatles 100 Greatest Songs.

As far as the above Mark Twain quote goes, it's indeed what we know for sure when it comes to global economic growth which is of concern to us, regardless of the supposedly "deflation escape velocity" reached by the US economy and its latest Nonfarm Payroll figures. We still sit tightly in the deflationary camp for the time being and remain extremely cautious about the risk posed by the velocity in the rise of the US dollar.

The Baltic Dry Index indicative that all is not good in global economic growth - graph source Bloomberg:

"Baltic Dry Index down to levels not seen since 1986" - source Bloomberg

You might therefore be wondering why we have used such a title as an analogy. Georges Harrison's musical masterpiece had an initial incantation, which we think, resonates well with the current investment environment and global central banks meddling in asset prices:

And when it comes to QE and Central Banks, an early acoustic guitar and organ demo of the famous song had a slightly different third verse which we find interesting for the sake of our analogy with our central banks "money" games:

"I look from the wings at the play you are staging,
While my guitar gently weeps.
As I'm sitting here, doing nothing but ageing,
Still, my guitar gently weeps."

In 2004, Harrison was inducted posthumously into the Rock and Roll Hall of Fame as a solo artist. "While My Guitar Gently Weeps" was played in tribute by Tom Petty, Jeff Lynne, Steve Winwood, Steve Ferrone, Marc Mann, and Dhani Harrison, and concluding with arguably one of the most memorable guitar solo by fellow inductee Prince but we ramble again.

In this conversation we will re-assess current trends and "rotations" and "look at the trouble" to see if it is indeed "raging" while our guitar gently weeps as well as musing around the impact QE has had in Europe so far.

Synopsis:

Lower expected returns and higher expected volatility

"Great rotation" not from bonds to equities but, from US equities to European equities in early 2015

European equities lift-off akin to the move seen on the Nikkei (hedged) in 2013but with less firepower!

Rising divergence between volatility and credit spreads in Europe

Lower expected returns and higher expected volatility

When it comes to the outlook for returns, we agree with Nomura's latest Strategic Outlook note from the 6th of February 2015, namely that we are going to see lower expected returns and higher expected volatility. We also share their concern on the US economy. We think it is more fragile than currently assumed:

"A common view is that the US economy is in good shape – effectively immobile against a stronger USD or lower energy prices or low productivity. With most of the rest of the world (ex Brazil) loosening monetary conditions (FX and rates) another view is emerging that EM growth will recover. And the ECB’s QE announcement should, it is argued, hedge downside inflation and hence growth risks in the euro area. These views rest squarely on the assumption that the US will not and never has slowed down from above trend growth without the intervention of the Fed via tight monetary policy. In contrast we see increasing evidence that the US profit cycle is in fact maturing rapidly and that profit growth is likely to disappoint through H1. If this is the case then slower capex and employment follow – regardless of the Fed. This would constitute a major surprise to global forecasts that are more clustered than they have been since 2007.

Given the starting point for inflation this scenario would generate further upside pressure on real yields across the curve. How risk aversion would respond is critical to predicting the outcomes for returns. By contrast the bullish growth scenario would, we think, lead to a rapid repricing of Fed hikes back toward June given the stage of the US cycle. Our unpalatable strategic conclusions are that growth estimates for H2 will probably need to come down, that real yields or nominal yields are going back up under most scenarios, and that risk aversion will continue to trend higher." - source Nomura

While we have taken the proverbial "beating" on our ETF ZROZ long duration exposure losing 7% since the 30th of January, we are sticking with our position, given our lower entry level in the trade (we have also exposure to a long term macro short term trade offsetting the short term pain via ETF YCS, being short JPY for disclosing purposes...). The recent widening in US Treasuries make a good entry point for those who missed out, we indeed, expect, the data in the US, from a contrarian perspective to be weaker than previously expected, regardless of the most recent NFP.

"Individual components of the employment report are at odds with other data. One of the fastest-growing components of employment, for example, was construction, with total head-counts up 5.5% year-on-year as of January. Construction spending adjusted for the construction Producer Price Index was flat year-on-year. Either the spending numbers were wrong (but unlikely because construction activity is easily counted) or the employment numbers are suspect."

- source Reorient Group

We agree with the above, that all is not what it seems and it demands a more inquisitive mind when it comes to taking the data at "face value".

"Great rotation not from bonds to equities but, from US equities to European equities in early 2015

From an allocation point of view, what we find of great interest has been the continued inflows into the bond sphere (59 straight weeks of inflows to Investment grade bond funds with $8.7bn) as indicated by Bank of America Merrill Lynch's Follow the Flow note from the 5th of February entitled "The Bond Capitulation":

In relation to Bank of America Merrill Lynch and its "Great Rotation" story, it seems that, courtesy of the ECB unleashing a QE of its own, the great rotation has clearly been from US equities into European equities it seems with $4.3bn of inflows for a 4 straight week, whereas the US saw $9.9bn of outflows for a 5 straight week. European assets seems to be a large beneficiary from the ECB's promises to deliver a QE of its own as indicated once more by Bank of America Merrill Lynch's Follow the Flow note from the 6th of February 2015 entitled "Income mania":

"Biggest inflows ever into European assets
Fund flows highlight the chronic shortage of yield in Europe. Last week saw the greatest ever total inflow into European assets (chart 2).

The reach for yield was in full effect across high-grade and high-yield credit, government bonds, money market funds, equities and commodity funds, according to EPFR. In terms of notable trends:
• Money-market inflows were the 4th highest ever.
• European equity inflows were the 6th biggest ever.
• Inflows into government bond funds were the 3rd largest ever.
• Inflows into all fixed-income funds were the 2nd biggest ever.
• High-grade credit flows were the 8th largest, since data began.
All in all, aggregate risk-on flows in to European assets were huge: almost $40bn!" - source Bank of America Merrill Lynch

At the same time and on a monthly basis, the S and P 500 saw during the month of January $28bn of outflows and equating to 15% of AUM according to Morgan Stanley. In fact, the biggest monthly outflow ever:

- graph source Bloomberg / Morgan Stanley

Also, investors continue to pile into the yield trade as the search for income runs unabated.

For instance IYR (REITS) had its largest daily inflow ever on the 2nd of February ($900 mln or 12% of AUM) according to Morgan Stanley:

- graph source Bloomberg / Morgan Stanley

We believe the great rotation story in 2015 currently playing out is indeed from US equities towards European equities for the time being and we agree with the following comments from Morgan Stanley:

"US investors are loaded up on US risk: 50% of the entire industry ETF flows since 2009 has gone into US equities ($300 bln).

The peak in global growth might very well have come in Q1 (US printed 5% GDP in Q3 and Q4 GDP came in 2.6% below the 3% consensus forecast). Now we have a strong dollar and we are starting to see countries implementing policy stimulus to close the gap in growth." - source Morgan Stanley

So indeed while our guitar is gently weeping, US risk is indeed much less appealing than European risk (Grexit avoided of course...).

Therefore, when it comes to allocation to European equities it is definitely on the "menu du jour" as displayed in Louis Capital Markets Cross Asset Weekly report from the 2nd of January:

"Run Forrest!
No client meeting we have conducted has passed without a question on the relative performance of European equities compared to US equities being posed. European investors are well loaded with European equities as they suffer the classic “home bias”, well known in academic literature. US investors are similarly biased, but the letters Q and E, that recently reared their head in Europe, have broadened their investment universe and a flow of money has poured into European equities. The US ETFs that hedge the currency impact have benefited strongly from this trend as we show in the chart below.

This re-balancing has happened in a context where Wall Street has started to show some signs of weaknesses. We have recently discussed this hypothesis and it seems that US indices have lost their upward momentum (at least, in the short term).
The reversal of the profit trend could be the reason for this weakness. Or perhaps this is simply a profit taking phase, because as we all know these are a regular occurrence in equity markets.
Sarcasm aside, the fact that European equities recorded new highs in this less than favourable context is therefore heroic, because on the profit side there is absolutely nothing new. The charts below illustrate this. We can understand that the impact of the EUR/USD is positive for European companies and negative for US companies, but in the earnings forecasts of analysts there is no change.

The 2015 EPS of the Eurostoxx50 has been revised down by 2.2% for the sole month of January.

Although we share the consensual view that the decline of the EUR/USD will support profits of the European index later this year, this 2.2% negative revision is a reminder that on an index level the macroeconomic developments that appear obvious to many investors are not so straightforward when it matters due to its composition/structure.

By sector, the message is consistent with the “currency advantage” as consumer stocks that are quite global have done better than more domestic sectors like utilities or financials. The telecoms sector, with its very strong performance, is the exception in Europe.
However, the difference in performance between the Eurostoxx and the S&P500 since the beginning of the year is broad based and not related to a specific sector. The underperformance of US financials compared to European financials sends a key message here: this is not only a matter of exchange rates.

The herd mentality is strong on equity markets with this run against time to chase European equities that keep a potential for a catch-up if we look at prices. If we look at valuation (without discussing the impact of possible different profit cycles and different profit trend growth) the potential for a catch-up is exhausted. We have updated our table on the valuation of the MSCI EMU if we apply to it the sector composition of the US index. Here, we find a mere 2.2% discount in terms of forward PER.

Last week we started mentioning the valuation aspect of the Europe/US question. To be clear, we stress that profits have to improve significantly to think that European indices can outperform on a sustainable basis its US peers." - source Louis Capital Markets

European equities lift-off akin to the move seen on the Nikkei (hedged) in 2013but with less firepower!

From an equity to credit perspective, one of the major impact from the ECB's QE has been the rising divergence between Eurostoxx 50 Put/Volatility versus Credit Spreads. This has been for us quite logical for Investment Grade, less so for High Yield. According to Goldman Sachs the spread between Out of the Money Put options on the Eurostoxx 50 and CDS spreads is at its highest level since 2010, and the yield that can be obtained by selling 70% put on the Eurostoxx 50 is 3 times higher than the Itraxx Main Europe CDS 5 year index (Investment Grade proxy for risk with 125 entities):

"We mentioned the problem of stocks and flows and the difference between the ECB and the Fed in our conversation "The European issue of circularity", given that while the Fed has been financing "stocks" (mortgages), while the ECB is financing "flows" (deficits). We do not know when European deficits will end, until a clear reduction of the deficits is seen, therefore the ECB liabilities will have to depreciate."

This major difference can already be seen, we think from the behavior of credit versus equities as discussed by Bank of America Merrill Lynch in their Credit Derivatives Strategist note from the 6th of February entitled "Catch the basis if you can":

"Central Banks liquidity primarily provides a strong back-stop against funding risks; rather than support earnings, which usually come further down the line. When the Fed announced the first QE program, credit spreads outperformed equities.

On the flip side, the ECB QE announcement has not ignited the same response. This time around credit lagged equities.

One could argue that European credit spreads are already close to the tightest levels in years, and thus should lag post an ECB QE announcement, especially when growth outlook is coming off the lows. At the end of the day the ECB QE is meant to boost growth rather than to reduce funding/default risks, and equity markets have started pricing that.

However, we expected Crossover to follow suit on the strong reaction from equity markets, being a growth proxy in the credit market. We were expecting Main to underperform Crossover in a QE event, also reflecting the same strong growth potential the equity markets are pricing.
However, XO has lagged the risk on move tighter. We think that this was not driven by the lack of yield in credit markets – as government bond yields have continued to rally – but mainly due to the rise of geopolitical risks and the resurfacing of funding risks." - source Bank of America Merrill Lynch

End of the day, it doesn't matter that European stocks have been racing ahead of fundamentals, from a "quality" and "japanification" perspective, it is still a goldilocks period for Investment Grade credit, particularly in a shift towards a new regime of higher volatility.

On a final note we leave you with Nomura's forecast of stock of assets purchased by central banks as a % of national GDP from their Economics Insights note of the 28th of January 2015 entitled "Comparing ECB QE with BOJ, Fed and BOE programmes:

"• BOJ holdings of JGBs are expected to increase from the equivalent of around 40% of Japanese GDP at the end of 2014 to around 60% of GDP by the end of this year. This compares with “only” 14% of GDP in the case of the Fed and just over 20% of GDP for the BoE.
• ECB purchases of sovereign bonds (just over €40bn a month, allocated according to the capital key) will be equivalent to around 4% of GDP by end-2015. These will have grown to about 7.5% of GDP by end-September 2016 (or around 13% of the total stock or 17% of the targeted stock; the latter referring to the maturity parameters of a remaining maturity of 2 years and a maximum remaining maturity of 30 years at the time of purchase).
• Only the Fed has engaged in macroeconomically significant (measured as a share of GDP) purchases of assets other than Treasuries, buying the equivalent of 10% of US GDP of Agency MBS. We estimate the ECB will maintain private sector asset purchases at around €10bn a month, resulting in purchases equivalent to just 1% of GDP by the end of this year and reaching 2% of GDP by the end of September 2016.
• In conclusion, if one believes in the effectiveness of QE (we don’t), then size probably matters. In this context, there are two considerations: (i) the increase in the stock of purchases is going to be gradual, which implies it is going to take some time for the cumulated size to become meaningful, and (ii) the cumulated expected size of the programme by the end of this year will still be only a third of the size of the Fed and BoE programmes, suggesting that, if you believe in the effectiveness of QE, the ECB’s programme will need to grow much more significantly before it has a macroeconomic impact." - source Nomura

“It's not the size of the dog in the fight, it's the size of the fight in the dog.” - Mark Twain